Thoughts on Recent Volatility

Given the recent spike in volatility across markets, I wanted to briefly communicate my thoughts on the situation and reinforce my views about volatility. Additionally, we discuss how we navigate through periods like this and why we believe our largest investments in Carvana and Cogent should accentuate our portfolio’s idiosyncratic performance which, hopefully, also should reduce its cyclical sensitivity.

1.      What happened?

On Sunday night/Monday morning, the VIX volatility index spiked to nearly 66, its third-highest level this century.  The prior times VIX spiked to these levels (and beyond) occurred during Covid (March 2020) and the Great Financial Crisis. 

Plenty of explanations are swirling around, including a weak employment report that fueled concerns of a recession.  However, the selloff began in Japan before the employment report came out, which triggered an unwind in the popular Japanese carry trade, whereby investors borrow yen at extremely low rates and invest that capital into higher-yielding assets in other countries.  When Japan’s central bank raised rates 25 bps, it triggered an unwind of that trade by tightening income spreads and strengthening the yen which had the effect of reducing assets and increasing liabilities.  Let’s walk through a simple example 

Let’s say Investor A borrows 100 million yen at 0%.  He converts those 100 million yen into $625,000 US dollars at an exchange rate of 160 yen per dollar and uses that to buy QQQ, which yields 0.65%.  He makes the 0.65% interest income spread and participates in appreciation in QQQ.  But then the following happens:

• Japan raises rates to 0.25%, which has two impacts:

  • He now must pay 0.25% interest on the 100 million yen he borrowed

  • The yen appreciates against the USD and now trades at 145 yen per dollar

• His $625,000 invested into QQQ is now worth only 90.6 million yen, excluding any changes in value to QQQ.  He has a 9.4 million yen deficit against his 100 million yen liability.  If the investment in QQQ has appreciated or depreciated from his cost basis (in USD) and if he used financial leverage, this may have created an asset/liability mismatch which may force him to liquidate other holdings or this specific carry trade to balance his accounts.

• His net income (dividends less interest expense) has declined from roughly $4,000 per year when he opened the trade.  He now must cover 0.25% of interest expense on his 100 million yen, or 250,000 yen ($1,725 in USD terms at 145 yen per dollar). 

This is one example, but there are many varieties of the Japanese carry trade, many of which include leverage to enhance returns.  Investors could deploy this strategy in any asset that generates yields above their yen-denominated borrowing costs.  However, when relative interest rates move rapidly, the trade can unwind quickly and can involve forced deleveraging and margin calls, which of course impacts highly liquid assets immediately. 

Capital markets are used by many participants for all types of investing and speculative activities.  Short- and long-term bets can be expressed across a wide swath of asset classes – currencies, bonds, stocks, derivatives, ETFs, and more. 

When there is an unwind of financial leverage in the system, the market experiences violent shocks of elevated volatility.  Highly correlated drawdowns are a feature of liquid capital markets and Recurve’s goal is to use it to our advantage—not to be fearful of these episodes. We are always looking for ways to go on offense when we see forced selling.

2.      What is Recurve doing about it?

Unsurprisingly for a long-only portfolio, Recurve has experienced a small drawdown in the first few days of August, but so far our month-do-date results are pretty modest and better than all of the major indices. 

Recurve manages a concentrated portfolio and sizable short-term swings are not uncommon for us.  If it weren’t for the spike in volatility across markets, this level of performance over four trading sessions—up or down—wouldn’t merit a response from us. However, the VIX rising to 66 is a rare occasion, so I thought it would be helpful to share some thoughts.

We didn’t have much excess cash in the portfolio, so we’ve made only a few modest top-ups during the violent part of the drawdown.  However, I don’t believe the volatility has been meaningful enough to warrant dramatic rotations or other changes within the portfolio. I would love for some of our watchlist to fall into our strike zone on valuation.

A core pillar of Recurve’s strategy is to embrace volatility.  As always, I am watching macro, fundamental, and valuation changes closely and will make changes to the portfolio opportunistically with a goal of upgrading quality, risk/reward skew, and the total return profile over a medium-term (2-3 year) time frame.   

 3.      What about macro weakening?

A weaker employment report last week elevated concerns of a harder landing. I refrain from making prognostications about macro outcomes and I don’t have any astonishing insights that give me an edge on what’s going to happen to the economy.  I’d be highly skeptical of anyone not named Druckenmiller that claims to predict macro outcomes and the corresponding market responses accurately over an investing career. 

There has been evidence of weakening among lower-end consumers and resilience among higher-end consumers.  It is a complex environment with inflationary pressure easing on a y/y basis and price deflation impacting some industries.  Clearly, the bond market is strongly suggesting that the Fed is behind the curve.  Additionally, short-term breakeven rates have plummeted recently, with 12-month inflation priced at 0.67% and 2-year inflation priced at 1.55%, while the 10-year breakeven rate is at 2.10%.  This looks like a recipe for near-term rate cuts to less restrictive territory, while keeping real rates in positive territory longer term. 

The path is unclear.  Certain industries that have been restricted by high rates may improve on a relative basis, even if aggregate growth is somewhat tepid.  Many of those industries have experienced deep recessionary conditions for 1-2 years already.  Or, the Fed could engineer a soft landing, and growth can remain strong for everyone, with relative outperformance in more cyclical industries (hence the rotation into the Russell 2000 in July).  Or, the Fed being behind the curve could tip the economy into a recession, hurting aggregate demand and impacting all industries, leading to lower earnings revisions over the coming year (hence the reversal of some of the Russell 2000 rotation trade in August).  All outcomes are possible.

I have tried to manage our portfolio to be less dependent on macro outcomes.  As I wrote in our recent Q2 Letter to Investors (access via our Letters page or e-mail info@recurvecap.com to request the password), our largest positions, Carvana (CVNA) and Cogent (CCOI), are highly disruptive to their markets which makes their fundamental performance more reliant on idiosyncratic factors than cyclical ones, and they can grow and gain share whether there are industry headwinds or tailwinds.  We have outsized exposure to them because they are offer exceptional risk/return skews, because they are more idiosyncratic than cyclical, and because they are the most disruptive companies in our portfolio.  They are building significant competitive advantages that grow with more scale and that improve the customer value proposition the bigger they get.  These qualities also hold true across our portfolio of Builder Companies.

While of course we don’t know how long this period of elevated volatility will last, Recurve stands ready to pounce and I will make changes and upgrade the portfolio if and when opportunities arise.